Value Investing:

Applying Graham and Buffett

Raimondas Lencevicius
Disclaimers

• I am not a registered investment advisor and I do not offer any

investment advise
• No parts of this talk are suggestions to invest, not invest, buy or
sell any kind of securities or other financial instruments
• For short term traders and technical analysis adherents:
• This talk is about fundamentals and long term investing (usually 6 months
to “forever”)
• I will not cover any topics of how to integrate TA or trading with value
investing
• This talk covers the way I practice Value Investing, there are
other ways to value invest that are not covered
• Not exact Buffett and Graham but my adaptation
Value investing - buying something cheaper than for
what it is worth

• Not very useful definition – this talk digs into it

• Different value investing approaches
• "Buffettology“ – buying cheap earnings in great companies
• "Net-nets", Graham – buying assets cheaply
Buffettology

• Buying stock is buying a business

• Is it a good business?
• Is it cheap?

• Is it good business?
• High ROE
• High margins
• Moat
ROE – Return on Equity

• Equity = All assets – all liabilities

• In simple cases: capital put into business
• ROE = Earnings/Equity
• How much business returns on what you have put into it
• Buy windmill for $10K, returns $1K in electricity production per year =
10% ROE
• Most businesses more complicated
Good ROE: >15% for last 5-10 years

• Based on cost of capital

• Businesses with lower ROE may not be returning cost of capital to
owners
• Examples:
• NKE 19.80 21.50 22.10 21.20 24.10
• GRMN 28.90 25.00 23.70 23.80 22.00 26.90 33.00 36.40
• Assumes low debt
• Usually < 1 D/E or < 0.5 D/E
• Zero debt is best - overcapitalized
• Can use ROIC if there is debt
• ROIC = Earnings / (Equity + Debt – Cash) = Earnings / (Assets – non-debt
liabilities - Cash)
• Cash flows vs. earnings
Net margins >10%

• High margins usually indicate some economic moat

• Pharmaceuticals, branded goods
• >15% operating margin, >10% net margin
• Possible to buy low margin businesses which are category killers
• Nike (7-10%), Walmart (3-4%), Cemex(4-8%), BNI (8-12%)
Company should have good moat

• Somewhat indicated by high long term ROE

• Somewhat indicated by high margins
• Subjective analysis
• Have things changed?
• Diworsefication – buying unrelated low margin businesses
• Squeezing out returns without regard to risk – FNM, monoline insurers
• Loss of patent protection – pharmas
• New threats – newspapers
• Value chain destruction – ratings agencies (Moody’s)
• Fads – Krispy Kreme, Crocs
• New moat creation – railroads
• Areas of expertise and areas outside "circle of knowledge“
Is business cheap?

• Value business for its earnings

• How much money would I make if this was my private company?
• How much money company will make in 10 years?
• Assuming average ROE what will be the earnings in 10 years?
• P/E in 10 years?
• Rate of return?
• Example: NKE
• Average ROE 20%
• Earnings in 10 years = ROE*Equity*(1+ROE)9 = $8B
• Market cap = $8B x P/E (15) = $121B
• Rate of return = ~13% after tax (calculations omitted)
• “Approximately right” calculation
• Do not decide 13.6 vs 13.2% situations, decide 5% vs 15% situations
• Discounted cash flow if needed
Caveats

• Very few companies are really “Buffettology” companies

• Few examples in these slides may not be true “Buffettology companies” J
• Need careful scrutiny
• Usually cheap when something is going wrong – is this temporary?
• New Coke, Amex disasters – temporary
• FNM, FRE – gone
• Moody’s?
• Think and discuss meticulously
• Usually large caps – followed by a lot of other people!
• Are you right while others are wrong?
“Net nets” – Graham – Asset based investing

• Buying a dollar for half dollar

• Still looking at whole business but very different from
Buffettology!
• Buy business, sell all assets = PROFIT!
• Buy antique watch from pawnshop for $1, sell to collector for $1000
• Usually small cap
• Usually smelly dinky cigar butt companies
• Can’t boast in a bar! J
Is this dollar selling for half-dollar?

• Best: below net cash value = cash + equivalents – all liabilities

• Very good: below net current assets =
current assets – all liabilities
• Good?: below book or tangible assets =
tangible assets – all liabilities
Analyzing assets

• Cash is king
• Cash equivalents may not be so! Need to check
• Current assets
• Inventory – how sellable it is?
• Accounts receivable – will company receive them?
• Other assets
• Plant, equipment – does it have any value at all?
• Land, real estate – may be undervalued or overvalued
• Usually no need to analyze liabilities – they are all real
Analyzing assets examples

• GSIT 1/2008:
• Current assets: 78M, liabilities 10M = 68M Net current asset value, 74M book
value
• Sold for 2.3-2.5 x 29M shares = 67-72M cap
• ACTS now:
• Current assets: 284M, liabilities 20M = 264M Net current asset value, 286M
book value
• Sells for about 2.8, 240M market cap
Beyond assets of net-net

• Earnings of net-net
• Profitability is preferable even if it is marginal
• Low debt
• Like in Buffettology
• High debt companies can go BK even with positive net assets
• Business outlook
• Perennial net nets: distributors
• Examples
• GSIT - profitable in Sep-Dec 2007, Jan-March 2008, no debt
• ACTS – profitable, no debt
Safety in value investing

• Buffettology
• Safety of great business
• Moat ensures that company will continue to earn great return on capital
• Future earnings returned to shareholders can ensure good return even if
there was no stock market
• Net-nets
• Safety of asset value
• Company can go private, be acquired, etc.
When to sell value investment?

• Buffettology
• Hold forever, pass to your kids and so on
• KO
• Hold till overvalued – expected return of future cash is too low
• BNI, KO in 2000, MA
• Net-nets
• Shorter term hold usually up to 2-3 years
• If does not work out in that time, probably perennial net-net
• Sell at 1.5-2x book
• Takeovers, takeunders, etc.
• Possibly short term capital gains, better in tax protected accounts
What to do when prices drop?

• For most value investments, prices drop after you buy them
• Buffettology
• If fundamental business has not changed – add
• If fundamental business has materially deteriorated – sell
• In reality decision is difficult, since business usually changes negatively
• AXP, MCO
• Net-nets
• If balance sheet has not changed and business is not going to lose a lot of
cash – add
• If balance sheet has deteriorated and company is no longer a net-net OR
business is going to lose a lot of cash – sell
• May be possible to use TA, stops, etc.
Value investing resources

• Value investors are cheap J

• Don’t buy subscriptions, don’t buy charting tools, don’t buy Value Line (well, maybe
J), don’t buy mansion, BMW, yacht, etc. J
• Company information
• 10 year data: http://www.gurufocus.com/ - some errors!
• 10 year data, graphs only for Quicken users:
http://investing.quicken.com/research/evaluator.asp?symbol=nke
• Recent financial statements: Yahoo Finance, Google Finance, SEC
• Ideas from other value investors
• Buffett, Berkshire Hathaway news, SEC fillings, etc
• Whitman, TAVFX letters to shareholders
• Ariel Fund letters to shareholders
• Blogs – just know which ones are value investors J
• Value Investing Congress
Questions and Future Plans

• Interested in:

• More in depth income sheet or balance sheet analysis talk?

• Value investing meetings – analyze concrete companies, stocks,
etc.
• Any other suggestions

• Raimondas@hotmail.com